Speech The Road to Recovery

The global economy is in recession. Virtually all of Australia's trading partners
are contracting. In fact almost every country with which we would normally
make comparisons is in recession, and for many of them it is a bad one.

It is very rare for Australia to escape an international downturn and there is no
precedent for avoiding one of this size. We, like most countries, have trade
and financial linkages to the rest of the world. We are all aware of what happens
abroad, and our own expectations and economic behaviour cannot but be affected
by those events. Whether or not the next GDP statistic, due in early June,
shows another decline, I think the reasonable person, looking at all the information
available now, would come to the conclusion that the Australian economy, too,
is in
recession.[1]

These are periods of hardship for significant parts of the community. People lose
jobs, businesses fail, loans go bad, and plans are unfulfilled. As such, they
are to be avoided if possible and at least ameliorated when they occur. It
is for the latter reason that most countries today have extensive social safety
nets, so that when recessions do occur, we can avoid the extent of outright
misery seen in episodes like the 1930s.

Policy-makers also seek to cushion such downturns with macroeconomic policy.
They are usually more successful if they have managed to restrain the preceding
boom. But no country's policy-makers have been able to eliminate
the business cycle, much as they have all tried. Cyclical behaviour has always
been a feature of market economies. It always will be. Should you see, at some
future time, a claim to the contrary, it would be advisable to treat it with
great scepticism and, indeed, as a possible indication that a cyclical turning
point is in the offing.

Most of the time, economic activity expands, as population growth, increasing wealth
and aspirations to higher living standards lead to more demand, while a growing
workforce, higher productivity and technological innovation push up supply
capacity. That is the normal situation for an economy.

But every so often – on average about once every seven or eight years, but
not regularly enough to predict with accuracy – a set of conditions arise
that see demand weaken for a while, output decline and unemployment rise. That
is a recession. Usually, though not always, inflation tends to fall as a result
of such episodes.

Modern Australia has experienced a number of recessions – in the early 1950s,
the early 1960s, the mid 1970s, the early 1980s, the early 1990s, and now in
2008/09. There were also events that could reasonably be labelled brief recessions
in 1957 and 1977. On that count, the current episode will be the eighth recession
since World War II. Most of these events have been associated with international
business cycles.

There were significant mid-cycle slowdowns, which did not develop into recessions,
in the mid 1960s and very early
1970s[2],
the mid 1980s, the mid 1990s and 2000/01. In each of these periods, output
slowed or even fell very briefly, the rate of unemployment stopped falling
and/or rose, and inflation moderated.

The 2000/01 episode was notable in that it coincided with a downturn in the major
countries. It was very unusual for Australia not to have a recession in such
circumstances, though as it was, the rate of unemployment rose by about a percentage
point in the space of a year. One aspect that helped us on that occasion was
that the downturn in many of the major countries was not an especially deep
one. Another was the continuing strength in some other key trading partners,
not least China. This time, the state of the global economy is much worse.

The extent of that weakness was unexpected. Until the financial crisis escalated
so dramatically last September, it appeared that some of the major countries
would have downturns, but that the emerging world, including Asia, would not
slow as much as on some other occasions. Although affected by weaker demand
from the industrialised world, many of these countries appeared largely to
be free both of the financial problems in the major countries and of the sorts
of problems they themselves had experienced in past episodes. The growth of
China seemed to be on a strong medium- term path, albeit with a cycle
like every other economy. This was not ‘de-coupling’, simply
the assessment that the net of competing forces would produce a significant
slowdown, but not a slump. Hence, global growth was generally expected to slow
to below average, after several years in which it had been unsustainably high.

Then, things took a serious turn for the worse. The financial turmoil following the
Lehman collapse was the most intense in generations. It was contained within
about six weeks, and indeed over the past few months conditions have been gradually
improving in financial markets, in several respects. But we are now seeing
the fallout in the rest of the economy from that financial turmoil. The weakened
ability of the financial institutions to provide credit to industry is one
of the factors at work, but in my judgment a bigger one is the decline in confidence,
and the sudden and widespread aversion to risk, among firms and households
all over the world. It seems that everyone, everywhere, having seen the instability
in financial systems in September and October 2008, and consequently feeling
poorer and fearing bad times ahead, simultaneously decided to pull back their
own spending, curtail their expansion plans and reduce their debt.

It was, of course, entirely rational, at the individual level, for firms and households
to behave in a more precautionary way. But the collective sum of those decisions
created, over the ensuing six months, an international slump in demand for
consumer durables and investment goods that was sharper, and more synchronised,
than any seen for decades. The result is that the world's gross product
is now thought likely to decline in 2009, the first time that has happened
for many decades.

Australians shared in this more cautious behaviour, particularly in the business
world. A range of business surveys indicate that a trend moderation in business
confidence that had been occurring for some months turned abruptly much weaker
in October, and remained weak thereafter (Graph 1). There was some recovery
in March. (The behaviour of Australian household confidence surveys has not
been as weak, as I shall come to later.) While official data are yet to show
it, it is likely that business investment spending is in the process of declining
sharply. Hiring intentions have been scaled back quickly. Residential investment
and exports have fallen.

Graph 1

The net result is that the Australian economy has been contracting, though on the
best information we have, not at the pace seen in a number of other countries,
where quarterly declines in real GDP of 3, 4 or even 5 per cent have been
observed in the last quarter of 2008 and are likely to have occurred in the
first quarter of 2009.

A key dimension through which Australia experiences the global business cycle is
the terms of trade, a gauge of the income gains or losses that international
relative price changes impart to Australia. Over the five years to 2008, a
period of exceptional strength in the global economy, the terms of trade rose
by about 60 per cent, equivalent to about 12 per cent of a year's
GDP– about $140 billion– in additional annual income. It was
the biggest such gain in half a century. Now, the terms of trade are falling,
reversing part, though so far only part, of that earlier gain.

I would like to make two points, however, about those terms of trade swings. The
first is that, in earlier episodes such as in the early 1950s, and the mid
and late 1970s, very large terms of trade movements seriously destabilised
the economy. On this occasion, there have been plenty of adjustment challenges–
generally coming under the heading of the so-called ‘two-speed
economy’, where the resource-intensive regions and industries grew
quickly and others slowed. But for all that, a floating exchange rate, a much
more flexible labour market and better macroeconomic policy frameworks have
helped the economy adapt to the terms of trade swings without the degree of
instability seen in the past. That is a testament to the arrangements that
are now in place.

The second point is that, at this stage, the fall in the terms of trade that is occurring
does not seem to be reversing all of the previous rise. Even with the large falls in prospect for contract prices for
bulk commodities, Australia's terms of trade look like they could, at
the end of this year, still be about 40 per cent higher than the average
for the period from 1980 to 2000. Perhaps that will not persist. Alternatively,
perhaps what commodities markets are telling us is that some factors beneficial
to Australia– foremost the continued likely emergence of China–
remain in place. It is probably not entirely coincidental that the clearest
signs of a turning point in economic activity appear to be accumulating in
China, though not exclusively there.

That is a quick description of where we are, and some of the background of how we
got here. I will not speak here of the broader background of the financial
excesses that helped to create the situation, because that has been covered
in detail before.

Instead, I want to devote some attention to the question: how do we get on the road
to recovery? History shows that recessions come, but also that they end. Can
we speed that process? And to the extent that we have some capacity to shape
the next expansion, how might we use it?

Since this is essentially an international episode, and not really an Australia-specific
one, much depends on what happens abroad. This neither means we are helpless
to affect our own future, nor absolves us of the responsibility to pursue sensible
policies to promote recovery here. I shall come to that, but first, a few words
about the conditions for a durable global recovery. I take it as given that
we all agree that a better financial regulatory architecture is needed and
there is a lot of work under way on that. But that is about avoiding a repeat
crisis. What about steps to get out of this one?

There are several necessary elements.

The first, as many have said, is to sort out the mess in the financial system, especially
in the United States, the United Kingdom and Europe. It is not an easy problem
to solve. But quite a lot is known from previous episodes, including in the
United States itself, of the main principles that must be observed in this
process.

The first step is an honest accounting of the situation. Then, the ‘legacy’
assets have to be quarantined so that the potential for further erosion of
their quality, and uncertainty over their value, does not lead to further loss
of bank capital and associated confidence problems. The relevant institutions
must then be recapitalised if need be, so that, freed of the problem loans,
they can resume normal commercial activity– lending for sound proposals.
It may be that, appropriately cleaned up, banks can attract new private capital.
If not, then public funds have to be made available to recapitalise them where
needed.

Everyone understands these principles. The question is how to implement them. There
are a few ways to go about it, all of which are on the table at present. One
is to hive off the problem assets into a ‘bad bank’ or some other
like vehicle, which is then managed and gradually wound down. The assets have
to be transferred at some price, and the process of striking that price has
to protect the interests of taxpayers, who should not over-pay for the
bad assets and thereby give a windfall to shareholders. At the same time, there
has to be pressure on the institutions concerned actually to get on with the
clean-up, as opposed to just waiting for something to turn up. The plan being implemented in the United States is designed
to induce private capital to take part in the asset management vehicles, which
helps to sort out the pricing question.

Another approach is to leave the assets on the banks' balance sheets, but have
the government insure them, for a price, to limit further downside. This is
the essence of the UK approach. Yet another approach is to nationalise the
relevant institutions, which obviates any pricing issues for the assets per se and automatically provides enough capital, but introduces
new questions in dealing with shareholders. This approach is the traditional
one, though it has mostly been used in smaller countries or, where used in
major countries, for smaller institutions.

The economics of all these approaches is essentially the same: recognising losses
that have occurred, reducing the riskiness of bank balance sheets and finding
new capital to restart the credit process. Which technique to choose is a matter
of judgment.

The politics may be harder than the economics. Ordinary people resent, not surprisingly,
taxpayer funds being used to fix problems that arose, in part at least, because
of seriously misaligned incentives that rewarded financiers for taking too
much risk. But it has to be done, otherwise economies will suffer for longer.
The political leaderships of the United States, the United Kingdom and some
other countries have the unenviable task of persuading their citizens to accept
the need for these initiatives.

A second near-term condition for recovery is macroeconomic support for aggregate
demand, in an environment in which private spending has weakened sharply, owing
to loss of confidence and strained credit markets. That is coming into place
as a result of easier monetary policy, and easier fiscal policy also in many
countries. Internationally, the role of fiscal policy is more prominent on
this occasion than has been the case for many years, since the impaired credit
system makes monetary policy less effective than it would normally be in many
countries. The reason official interest rates are approaching zero in a growing
list of countries is not because central banks think it is a good idea to make
credit available for free. It is because the flow-through from official
rates to the rates that matter most in these economies– those paid by
businesses and households– has not been working very well.

Third, with these near-term policy requirements– repairing the financial
system and macroeconomic stimulus– come associated medium-term
requirements, which fall under the heading of ‘exit strategies’.

For those countries where governments end up owning part or all of banks, there will
need to be a plan to divest that holding when conditions improve. The same
can be said of the various guarantees under which banks globally are raising
money at present. This was an important step to help the system through a period
of severe dislocation, but it is surely not desirable as a permanent state
of affairs. At some point, it will be prudent to start weaning banks, or more
to the point investors, off those guarantees. Perhaps co-ordinating such
a departure across countries would be a useful role for the Financial Stability
Board.

The other international exit strategy needed will be on macroeconomic policies. The
size of the downturn, the extent of fiscal stimulus and the cost of the financial
restructuring packages have placed a very large burden on government finances
in a number of countries. I am not arguing against the measures. But they will
need to be accompanied by a credible story about how governments will keep
their own finances on a sustainable footing over time. Taxpayers, markets and
creditors will lose, rather than gain, confidence if they cannot see that path
back to sustainability. And, at this point, confidence is what it is all about.
The same issues will arise for the exceptional monetary policy measures.

The fourth condition for a durable new international expansion is to avoid perpetuating
the so-called ‘global imbalances’. The excess of saving over
investment in the emerging world, especially Asia, was one part of the story
of how the search for yield led to excessive risk-taking. This is not
to blame Asia for the crisis, but simply to state the obvious: that for people
to misuse abundant capital as they did, there has to be a fair bit of it around
to begin with. As it has turned out, there was more of it than the United States
and some other developed countries were able to use wisely.

So to the extent that strong global growth relied on advanced country consumers lowering
their saving rates, absorbing the export surpluses of the emerging world, and
accepting higher debt burdens, the model is broken. Of course, the most important
matter in the immediate term is for the US economy to resume growth. But even
when it does, the reality is that for some time ahead, advanced country households
will be looking to lower their debt burdens and save more of their income.
They will not be the same spur to consumption growth as they were.

This will mean that global growth will be, for a while at least, lower on average
than we saw for most of the past decade. How much lower will depend in part
on the extent to which the economies in the emerging world are able to foster
more demand at home. For them to feel safe in doing that, and perhaps to return
to their traditional position as capital importers, there will be other conditions–
not least confidence on their part that the rules of international engagement
are not just skewed to the advantage of the advanced countries. In the end,
though, durable growth will have to be more balanced than the growth we had
over the past decade.

To the above, I should add that maintaining openness to trade and capital flows is
critical– lest the mistakes of the 1930s be repeated. This should hardly
need saying, yet times of serious recession are often times when protectionist
sentiments grow stronger.

That is all I have to say today on the global conditions for recovery.

Turning closer to home, Australians cannot do a great deal to make these improved
international conditions come to pass. But we can maximise our chances of benefiting
from a new international expansion.

The first thing is to maintain some confidence in ourselves and the prospects for
our country over time. We cannot achieve effortless prosperity either on the
back of ever-escalating mineral prices or simply by bidding up the prices
of our houses. It is as well to realise that. But as I have said on previous
occasions, Australia's genuine long-term economic prospects remain
good, and there remain good grounds to think that we will continue to weather
the storm better than most.

It is noteworthy that in measures of confidence taken from surveys, household confidence
has fallen in Australia relative to the ebullient levels of a year ago, but
it remains much more resilient to date than comparable results in major countries
(Graph 2). While households expect unemployment to be much higher in a
year's time, their stated expectations about economic conditions five
years from now have barely diminished at all from what we have seen consistently
over a number of years (Graph 3). So notwithstanding their evident caution
at present, people remain essentially optimistic about the long term.

Graph 2

Graph 3

Consumer demand in Australia, while weak compared with recent years, is actually
at the stronger end of international comparisons among advanced countries.
This presumably owes something to the stimulatory effects of fiscal measures
and lower interest rates for borrowers (though savers are feeling the pinch).
But perhaps it also shows the inherently optimistic view Australians take in
the future. Optimism, combined with an awareness of risk, is a fundamental
strength. It is to be hoped that this will be matched by a recovery in business
confidence over the months ahead. That remains to be seen, though there have
been some encouraging signs recently.

What can policy-makers do to help? Unfortunately, there is no lever marked
‘confidence’ that policy- makers can take hold of. Our task
is very much one of seeking to behave, across the board, in ways that will
foster, rather than erode, confidence. Over the past six months, that has,
of course, involved the rapid deployment of both fiscal and monetary measures,
to support demand. The effects of those measures will still be coming through
for some time yet. Measures to sustain confidence in the financial sector and
to keep key markets functioning were also important.

Perhaps there is also some value in articulating a view of where we want to get to
when the cyclical downturn ends, as it will, and recovery takes hold. What
sort of country does Australia want to be, economically, during the next expansion?
How do we want to be positioned in the global marketplace for capital, in an
environment in which markets will have absorbed a lot of government debt and
will be evaluating opportunities for other uses of capital?

I suggest that Australia has a very good chance of offering an economic setting in
which the following conditions hold.

Second, the Government does not own, and has not had to give direct financial support
to, the banking system. Australia will be free of the difficult governance
and exit strategy issues that such support is raising in a number of countries.

Third, public finances remain in very sound shape, with modest debt levels and a
medium-term path for the budget back towards balance. Without the massive
obligations arising from bank rescues that will inevitably narrow the options
available to governments in other countries, Australia should be able to articulate
such a path more effectively than most.

Fourth, sensible policy frameworks– both macroeconomic and microeconomic–
remain in place; the financial regulatory system is strong and tested.

Fifth, we remain open for trade and investment, and have a capacity to deploy both
our own and other people's capital carefully and profitably.

Finally, there is an exposure to, and an engagement with, an Asian region that still
has the most dynamic growth potential in the world, where hundreds of millions
of people will for decades to come be seeking rising living standards.

There are rather few countries that have the potential to offer so attractive a proposition
to international capital, and to their own citizens, over the years ahead.
It is a proposition that, if pursued sensibly and consistently, offers the
most secure basis for confidence in Australia's future. It is such confidence
that, more than anything else, will help to drive us along the road to recovery.

Endnotes

Perhaps it is useful to be clear what we mean by the term ‘recession’.
The original definition is ‘a significant decline in economic activity
spread across the economy, lasting more than a few months, normally visible
in production, employment, real income, and other indicators’. This
is the working definition of the National Bureau of Economic Research (NBER),
and is based on Burns AF and WC Mitchell (1946), Measuring Business Cycles, NBER, New York. [1]

In both those cases, by the way, if we applied the ‘two negative growth quarters’
definition, they would be labelled recessions. No-one remembers them
as recessions, though, which perhaps illustrates why that definition is not
very useful. [2]